Chapter 7:

The Theory and Estimation of

Cost

The Importance of Cost

in Managerial Decisions
Ways to contain or cut costs over the
past decade
Most common: reduce number of people
on the payroll
Outsourcing components of the business
Merge, consolidate, then reduce
headcount

The Definition and Use of

Cost in Economic Analysis
Relevant cost: a cost that is affected by
a management decision.
Historical cost: cost incurred at the time
of procurement.
Opportunity cost: amount or subjective
value that is forgone in choosing one
activity over the next best alternative.
Incremental cost: varies with the range
of options available in the decision.

The Relationship Between

Production and Cost
Cost function is simply the
production function expressed in
monetary rather than physical units.
Assume the firm is a price taker in
the input market.

The Relationship Between

Production and Cost
Total Variable Cost (TVC): the cost
associated with the variable input,
determined by multiplying the
number of units by the unit price.
Marginal Cost (MC): the rate of
TVC
W
change in total variable
cost.
MC

MP

The law of diminishing returns

implies that MC will eventually
increase

The Relationship Between

Production and Cost
Plotting TP and TVC
illustrates that they
are mirror images
of each other.
When TP increases
at an increasing
rate, TVC increases
at a decreasing
rate.

The Short-Run Cost Function

For simplicity the following assumptions
are made:

The firm employs two inputs, labor and capital.

The firm operates in a short-run production
period where labor is variable, capital is fixed.
The firm uses the inputs to produce a single
product.
The firm operates with a fixed level of
technology.
The firm operates at every level of output in
the most efficient way.
The firm operates in perfectly competitive
input markets and must pay for its inputs at a
given market rate. It is a price taker in the
input markets.

The Short-Run Cost Function

Standard variables in the short-run
cost function:

Quantity (Q): the amount of output that

a firm can produce in the short run.
Total fixed cost (TFC): the total cost of
using the fixed input, capital (K)
Total variable cost (TVC): the total cost
of using the variable input, labor (L)
Total cost (TC): the total cost of using all
the firms inputs, L and K.
TC = TFC + TVC

The Short-Run Cost Function

Standard variables in the short-run cost function:
Average fixed cost (AFC): the average per-unit cost of
using the fixed input K.
AFC = TFC/Q
Average variable cost (AVC): the average per-unit cost
of using the variable input L.
AVC = TVC/Q
Average total cost (AC) is the average per-unit cost of
using all the firms inputs.
AC = AFC + AVC = TC/Q
Marginal cost (MC): the change in a firms total cost (or
total variable cost) resulting from a unit change in
output.
MC = TC/Q = TVC/Q

The Short-Run Cost Function

Graphical example of the cost
variables

The Short-Run Cost Function

Important Observations
AFC declines steadily over the range of
production.
When MC = AVC, AVC is at a minimum.
When MC < AVC, AVC is falling.
When MC > AVC, AVC is rising.
The same three rules apply for average
cost (AC) as for AVC.

The Short-Run Cost Function

A reduction in the firms fixed cost
would cause the average cost line to
shift downward.
A reduction in the firms variable cost
would cause all three cost lines (AC,
AVC, MC) to shift.

The Short-Run Cost Function

Alternative specifications of the Total Cost
function
Most commonly: specified as a cubic
relationship between total cost and output
As output increases, total cost first increases at a
decreasing rate, then increases at an increasing rate.

Quadratic relationship
As output increases, total cost increases at an
increasing rate.

Linear relationship
As output increases, total cost increases at a constant
rate.

The Long-Run Cost Function

In the long run, all inputs to a firms
production function may be changed.
Because there are no fixed inputs, there
are no fixed costs.
The firms long run marginal cost pertains
to returns to scale.
First, increasing returns to scale.
As firms mature, they achieve constant
returns, then ultimately decreasing returns to
scale.

The Long-Run Cost Function

When a firm experiences increasing
returns to scale:
A proportional increase in all inputs
increases output by a greater
proportion.
As output increases by some
percentage, total cost of production
increases by some lesser percentage.

The Long-Run Cost Function

Economies of Scale: situation where
a firms long-run average cost (LRAC)
declines as output increases.
Diseconomies of Scale: situation
where a firms LRAC increases as
output increases.
In general, the LRAC curve is ushaped.

The Long-Run Cost Function

Reasons for long-run economies

Specialization in the use of labor and

capital.
Prices of inputs may fall as the firm
realizes volume discounts in its
purchasing.
Use of capital equipment with better
price-performance ratios.
Larger firms may be able to raise funds
in capital markets at a lower cost than
smaller firms.
Larger firms may be able to spread out
promotional costs.

The Long-Run Cost Function

Reasons for Diseconomies of Scale
Scale of production becomes so large
that it affects the total market demand
for inputs, so input prices rise.
Transportation costs tend to rise as
production grows.
Handling expenses, insurance, security, and
inventory costs affect transportation costs.

The Long-Run Cost Function

In long run, the firm
can choose any level
of capacity.
Once it commits to a
level of capacity, at
least one of the inputs
must be fixed. This
then becomes a shortrun problem.
The LRAC curve is an
envelope of SRAC
curves, and outlines
the lowest per-unit
costs the firm will incur
over a range of output.

The Learning Curve

Learning Curve: line showing the relationship
between labor cost and additional units of output.
Downward slope indicates additional cost per unit
declines as the level of output increases because
workers improve with practice.
Measured in terms of percentage decrease in
additional labor cost as output doubles.
Yx = Kxn

Yx = Units of factor or cost to produce the xth unit

K = Factor units or cost to produce the Kth
(usually first) unit
x = Product unit (the xth unit)
n = log S/log 2
S = Slope parameter

Economies of Scope
Economies of Scope: reduction of a
firms unit cost by producing two or
more goods or services jointly rather
than separately.
Closely related to economies of
scale.

Ways Companies Have Cut

Costs to Remain Competitive
The Strategic Use of Cost
Reduction in Cost of Materials
Using Information Technology to Reduce
Costs
Reduction of Process Costs
Relocation to Lower-Wage Countries or
Regions
Mergers, Consolidation, and Subsequent
Downsizing
Layoffs and Plant Closings

Copyright
Keat and Young